Module 3

Fundamental Analysis

Module 3 — Fundamental Analysis

Chapter 1

Introduction to Fundamental Analysis

1.1 – Overview

Fundamental Analysis (FA) is a holistic approach to study a business. When an

investor wishes to invest in a business for the long term (say 3 – 5 years) it becomes

extremely essential to understand the business from various perspectives. It is

critical for an investor to separate the daily short term noise in the stock prices and

concentrate on the underlying business performance. Over the long term, the stock

prices of a fundamentally strong company tend to appreciate, thereby creating

wealth for its investors.

We have many such examples in the Indian market. To name a few, one can think of

companies such as Infosys Limited, TCS Limited, Page Industries, Eicher Motors,

Bosch India, Nestle India, TTK Prestige etc. Each of these companies have delivered

on an average over 20% compounded annual growth return (CAGR) year on year for

over 10 years. To give you a perspective, at a 20% CAGR the investor would double

his money in roughly about 3.5 years. Higher the CAGR faster is the wealth creation

process. Some companies such as Bosch India Limited have delivered close to 30%

CAGR. Therefore, you can imagine the magnitude, and the speed at which wealth is

created if one would invest in fundamentally strong companies.

Here are long term charts of Bosch India, Eicher Motors, and TCS Limited that can

set you thinking about long term wealth creation. Do remember these are just 3

examples amongst the many that you may find in Indian markets.

At this point you may be of the opinion that I am biased as I am selectively posting

charts that look impressive. You may wonder how the long term charts of

companies such as Suzlon Energy, Reliance Power, and Sterling Biotech may look?

Well here are the long term charts of these companies:

These are just 3 examples of the wealth destructors amongst the many you may

find in the Indian Markets.

The trick has always been to separate the investment grade companies which create

wealth from the companies that destroy wealth. All investment grade companies

have a few common attributes that sets them apart. Likewise all wealth destructors

have a few common traits which is clearly visible to an astute investor.

Fundamental Analysis is the technique that gives you the conviction to invest for a

long term by helping you identify these attributes of wealth creating companies.

1.2 – Can I be a fundamental analyst?

Of course you can be. It is a common misconception that only chartered

accountants and professionals from a commerce background can be good

fundamental analysts. This is not true at all. A fundamental analyst just adds 2 and 2

to ensure it sums up to 4. To become a fundamental analyst you will need few basic

skills:

1. Understanding the basic financial statements

2. Understand businesses with respect to the industry in which it operates

3. Basic arithmetic operations such as addition, subtraction, division, and

multiplication

The objective of this module on Fundamental Analysis is to ensure that you gain the

first two skill sets.

1.3 – I’m happy with Technical Analysis, so why bother about Fundamental

Analysis?

Technical Analysis (TA) helps you garner quick short term returns. It helps you time

the market for a better entry and exit. However TA is not an effective approach to

create wealth. Wealth is created only by making intelligent long term investments.

However, both TA & FA must coexist in your market strategy. To give you a

perspective, let me reproduce the chart of Eicher Motors:

Let us say a market participant identifies Eicher motors as a fundamentally strong

stock to invest, and therefore invests his money in the stock in the year 2006. As you

can see the stock made a relatively negligible move between 2006 and 2010. The

real move in Eicher Motors started only from 2010. This also means FA based

investment in Eicher Motors did not give the investor any meaningful return

between 2006 and 2010. The market participant would have been better off taking

short term trades during this time. Technical Analysis helps the investor in taking

short term trading bets. Hence both TA & FA should coexist as a part of your market

strategy. In fact, this leads us to an important capital allocation strategy called “The

Core Satellite Strategy”.

Let us say, a market participant has a corpus of Rs.500,000/-. This corpus can be

split into two unequal portions, for example the split can be 60 – 40. The 60% of

capital which is Rs.300,000/- can be invested for a long term period in fundamentally

strong companies. This 60% of the investment makes up the core of the portfolio.

One can expect the core portfolio to grow at a rate of at least 12% to 15% CAGR year

on year basis.

The balance 40% of the amount, which is Rs.200,000/- can be utilized for active short

term trading using Technical Analysis technique on equity, futures, and options. The

Satellite portfolio can be expected to yield at least 10% to 12% absolute return on a

yearly basis.

1.4 – Tools of FA

The tools required for fundamental analysis are extremely basic, most of which are

available for free. Specifically you would need the following:

1. Annual report of the company – All the information that you need for FA is available

in the annual report. You can download the annual report from the company’s

website for free

2. Industry related data – You will need industry data to see how the company under

consideration is performing with respect to the industry. Basic data is available for

free, and is usually published in the industry’s association website

3. Access to news – Daily News helps you stay updated on latest developments

happening both in the industry and the company you are interested in. A good

business news paper or services such as Google Alert can help you stay abreast of

the latest news

4. MS Excel – Although not free, MS Excel can be extremely helpful in fundamental

calculations

With just these four tools, one can develop fundamental analysis that can rival

institutional research. You can believe me when I say that you don’t need any other

tool to do good fundamental research. In fact even at the institutional level the

objective is to keep the research simple and logical.

Key takeaways from this chapter

1. Fundamental Analysis is used to make long term investments

2. Investment in a company with good fundamentals creates wealth

3. Using Fundamental Analysis one can separate out an investment grade company

from a junk company

4. All investment grade companies exhibit few common traits. Likewise all junk

companies exhibit common traits

5. Fundamental analysis helps the analysts identify these traits

6. Both Technical analysis and fundamental analysis should coexist as a part of your

market strategy

7. To become a fundamental analyst, one does not require any special skill. Common

sense, basic mathematics, and a bit of business sense is all that is required

8. A core satellite approach to the capital allocation is a prudent market strategy

9. The tools required for FA are generally very basic, most of these tools are available

for free.

Module 3 — Fundamental Analysis

Chapter 2

Mindset of an Investor

2.1– Speculator Vs Trader Vs Investor

Depending on how you would like to participate in the market, you can choose to

speculate, trade or invest. All the three types of participation are different from one

another. One has to take a stance on the type of market participant he would like to

be. Having clarity on this can have a huge impact on his Profit & Loss account.

To help you get this clarity, let us consider a market scenario and identify how each

one of the market participants (speculator, trader, and investor) would react to it.

SCENARIO

RBI in the next two days is expected to convene to announce their latest stance on

the monetary policy. Owing to the high and sticky inflation, RBI has hiked the

interest rates during the previous 4 monetary policy reviews. Increase in interest

rates, as we know means tougher growth prospects for Corporate India – hence

corporate earnings would take a hit.

Assume there are three market participants – Sunil, Tarun, and Girish. Each of them

view the above scenario differently, and hence would take different actions in the

market. Let us go through their thought process.

(Please note: I will briefly speak about option contracts here, this is only for

illustration purpose. We will understand more about derivatives in the subsequent

modules)

Sunil: He thinks through the situation and his thought process is as follows:

o He feels the interest rate are at an unsustainably high level

o High interest rates hampers the growth of corporate India

o He also believes that RBI has hiked the interest rates to a record high level and it

would be really tough for RBI to hike the rate again

o He looks at what the popular analysts on TV are opinionating about the situation,

and he is happy to note that his thoughts and the analyst thoughts are similar

o He concludes that RBI is likely to cut the rates if not for keeping the interest rates

flat

o As an outcome, he expects the market to go up

To put his thoughts into action, he buys call options of State Bank of India.

Tarun: He has a slightly different opinion about the situation. His thought process is

as below:

o He feels expecting RBI to cut the rates is wishful thinking. In fact he is of the opinion

that nobody can clearly predict what RBI is likely to do

o He also identifies that the volatility in the markets is high, hence he believes that

option contracts are trading at very high premiums

o He knows from his previous experience (via back testing) that the volatility is likely

to drop drastically just after RBI makes its announcement

To put his thoughts into action, he sells 5 lots of Nifty Call options and expects

to square off the position just around the announcement time.

Girish: He has a portfolio of 12 stocks which he has been holding for over 2 years.

Though he is a keen observer of the economy, he has no view on what RBI is likely

to do. He is also not worried about the outcome of the policy as he anyway plans to

hold on to his shares for a long period of time. Hence with this perspective he feels

the monetary policy is yet another short term passing tide in the market and will not

have a major impact on his portfolio. Even if it does, he has both the time and

patience to hold on to his shares.

However, Girish plans to buy more of his portfolio shares if the market overreacts to

the RBI news and his portfolio stocks falls steeply after the announcement is made.

Now, what RBI will eventually decide and who makes money is not our concern. The

point is to identify who is a speculator, a trader, and an investor based on their

thought process. All the three men seem to have logic based on which they have

taken a market action. Please note, Girish’s decision to do nothing itself is a market

action.

Sunil seems to be highly certain on what RBI is likely to do and therefore his market

actions are oriented towards a rate cut. In reality it is quite impossible to call a shot

on what RBI (or for that matter any regulator) will do. These are complex matters

and not straightforward to analyze. Betting on blind faith, without a rational

reasoning backing ones decision is speculation. Sunil seems to have done just that.

Tarun has arrived at what needs to be done based on a plan. If you are familiar with

options, he is simply setting up a trade to take advantage of the high options

premium. He is clearly not speculating on what RBI is likely to do as it does not

matter to him. His view is simple – volatility is high; hence the premiums are

attractive for an options seller. He is expecting the volatility to drop just prior to RBI

decision.

Is he speculating on the fact that the volatility will drop? Not really, because he

seems to have back tested his strategy for similar scenarios in the past. A trader

designs all his trades and not just speculates on an outcome.

Girish, the investor on the other hand seems to be least bit worked up on what RBI

is expected to do. He sees this as a short term market noise which may not have

any major impact on his portfolio. Even if it did have an impact, he is of the opinion

that his portfolio will eventually recover from it. Time is the only luxury markets

offer, and Girish is keen on leveraging this luxury to the maximum. In fact he is even

prepared to buy more of his portfolio stocks in case the market overreacts. His idea

is to hold on to his positions for a long period of time and not get swayed by short

term market movements.

All the three of them have different mindsets which leads them to react differently

to the same situation. The focus of this chapter is to understand why Girish, the

investor has a long term perspective and not really bothered about short term

movements in the market.

2.2 – The compounding effect

To appreciate why Girish decided to stay invested and not really react to short term

market movement, one has to understand how money compounds. Compounding

in simple terms is the ability of money to grow when the gains of year 1 is

reinvested for year 2.

For example consider you invest Rs.100 which is expected to grow at 20% year on

year (recall this is also called the CAGR). At the end of the first year the money is

expected to grow to Rs.120. At the end of year 1 you have two options:

1. Let Rs.20 in profits remain invested along with the original principal of Rs.100 or

2. Withdraw the profits of Rs.20.

You decide not withdraw Rs.20 profit; instead you decide to reinvest the money for

the 2

year. At the end of 2

year, Rs.120 grows to Rs.144. At the end of 3

year

Rs.144 grows to Rs.173. So on and so forth.

Compare this with withdrawing Rs.20 profits every year. Had you opted to withdraw

Rs.20 every year then at the end of 3

year the profits would have been just Rs. 60.

However since you decided to stay invested, the profits at the end of 3 years is

Rs.173. A good Rs.13 or 21.7% over Rs.60 is generated just because you opted to do

nothing and decided to stay invested. This is called the compounding effect. Let us

take this analysis a little further, have a look at the chart below:

The chart above shows how Rs.100 invested at 20% grows over a 10 year period. If

you notice, it took almost 6 years for the money to grow from Rs.100 to Rs.300.

However the next Rs.300 was generated in only 4 years i.e from the 6th to 10th

year.

This is in fact the most interesting property of the compounding effect. The longer

you stay invested, the harder (and faster) the money works for you. This is exactly

why Girish decided to stay invested – to exploit the luxury of time that the market

offers.

All investments made based on fundamental analysis require the investors to stay

committed for the long term. The investor has to develop this mindset while he

chooses to invest.

2.3 – Does investing work?

Think about a sapling – if you give it the right amount of water, manure, and care

would it not grow? Of course it will. Likewise, think about a good business with

healthy sales, great margins, innovative products, and an ethical management. Is it

not obvious that the share price of such companies would appreciate? In some

situations the price appreciation may delay (recall the Eicher Motors chart from

previous chapter), but it certainly will always appreciate. This has happened over

and over again across markets in the world, including India.

An investment in a good company defined by investable grade attributes will

always yield results. However, one has to develop the appetite to digest short term

market volatility.

2.4 – Investible grade attributes? What does that mean?

Like we discussed briefly in the previous chapter, an investible grade company has a

few distinguishable characteristics. These characteristics can be classified under two

heads namely the ‘Qualitative aspect’ and the ‘Quantitative aspects’. The process of

evaluating a fundamentally strong company includes a study of both these aspects.

In fact in my personal investment practice, I give the qualitative aspects a little more

importance over the quantitative aspects.

The Qualitative aspect mainly involves understanding the non numeric aspects of

the business. This includes many factors such as:

1. Management’s background – Who are they, their background, experience,

education, do they have the merit to run the business, any criminal cases against

the promoters etc

2. Business ethics – is the management involved in scams, bribery, unfair business

practices

3. Corporate governance – Appointment of directors, organization structure,

transparency etc

4. Minority shareholders – How does the management treat minority shareholders,

do they consider their interest while taking corporate actions

5. Share transactions – Is the management buying/selling shares of the company

through clandestine promoter groups

6. Related party transactions – Is the company tendering financial favors to known

entities such as promoter’s relatives, friends, vendors etc at the cost of the

shareholders funds?

7. Salaries paid to promoters – Is the management paying themselves a hefty salary,

usually a percentage of profits

8. Operator activity in stocks – Does the stock price display unusual price behavior

especially at a time when the promoter is transacting in the shares

9. Shareholders – Who are the significant shareholders in the firm, who are the

people with above 1% of the outstanding shares of the company

10. Political affiliation – Is the company or its promoters too close to a political party?

Does the business require constant political support?

11. Promoter lifestyle – Are the promoters too flamboyant and loud about their

lifestyle? Do they like to display their wealth?

A red flag is raised when any of the factors mentioned above do not fall in the right

place. For example, if a company undertakes too many related party transactions

then it would send a signal of favoritism and malpractice by the company. This is

not good in the long run. So even if the company has great profit margins,

malpractice is not acceptable. It would only be a matter of time before the market

discovers matters pertaining to ‘related party transactions’ and punishes the

company by bringing the stock price lower. Hence an investor would be better off

not investing in companies with great margins if such a company scores low on

corporate governance.

Qualitative aspects are not easy to uncover because these are very subtle matters.

However a diligent investor can easily figure this out by paying attention to annual

report, management interviews, news reports etc. As we proceed through this

module we will highlight various qualitative aspects.

The quantitative aspects are matters related to financial numbers. Some of the

quantitative aspects are straightforward while some of them are not. For example

cash held in inventory is straight forward however ‘inventory number of days’ is not.

This is a metric that needs to be calculated. The stock markets pay a lot of attention

to quantitative aspects. Quantitative aspects include many things, to name few:

1. Profitability and its growth

2. Margins and its growth

3. Earnings and its growth

4. Matters related to expenses

5. Operating efficiency

6. Pricing power

7. Matters related to taxes

8. Dividends payout

9. Cash flow from various activities

10. Debt – both short term and long term

11. Working capital management

12. Asset growth

13. Investments

14. Financial Ratios

The list is virtually endless. In fact, each sector has different metrics. For example:

For a retail Industry:

For an Oil and Gas Industry:

1. Total number of stores

2. Average sales per store

3. Total sales per square foot

4. Merchandise margins

5. Owned store to franchisee ratio

1. Oil to Natural Gas revenue ratio

2. Exploration costs

3. Opening oil balance (inventory)

4. Developed reserves

5. Total production growth

Over the next few chapters we will understand how to read the basic financial

statements, as published in the annual report. As you may know, the financial

statement is the source for all the number crunching as required in the analysis of

quantitative aspects.

Key takeaways from this chapter:

1. The mindset of a trader and an investor is different

2. The investor has to develop an investment mindset if he is serious about investing

3. The investor should stay invested for a long period of time for the returns to

compound

4. The speed at which the money doubles increases drastically the more time you stay

invested. This is one of the properties of compounding

5. Every investment has to be evaluated on two aspects – qualitative & quantitative

6. Qualitative aspects revolve around the non numeric information related to the

company

7. The quantitative aspects involve analyzing numeric data. The financial statements

are the important source of finding the quantitative data.

Module 3 — Fundamental Analysis

Chapter 3

How to Read the Annual Report of a

Company

3.1 – What is an Annual Report?

The annual report (AR) is a yearly publication by the company and is sent to the

shareholders and other interested parties. The annual report is published by the

end of the Financial Year, and all the data made available in the annual report is

dated to 31

March. The AR is usually available on the company’s website (in the

investors section) as a PDF document or one can contact the company to get a hard

copy of the same.

Since the annual report is published by the company, whatever is mentioned in the

AR is assumed to be official. Hence, any misrepresentation of facts in the annual

report can be held against the company. To give you a perspective, AR contains the

auditor’s certificates (signed, dated, and sealed) certifying the sanctity of the

financial data included in the annual report.

Potential investors and the present shareholders are the primary audience for the

annual report. Annual reports should provide the most pertinent information to an

investor and should also communicate the company’s primary message. For an

investor, the annual report must be the default option to seek information about a

company. Of course there are many media websites claiming to give the financial

information about the company; however the investors should avoid seeking

information from such sources. Remember the information is more reliable if we

get it get it directly from the annual report.

Why would the media website misrepresent the company information you may ask?

Well, they may not do it deliberately but they may be forced to do it due to other

factors. For example the company may like to include ‘depreciation’ in the expense

side of P&L, but the media website may like to include it under a separate header.

While this would not impact the overall numbers, it does interrupt the overall

sequencing of data.

3.2 – What to look for in an Annual Report?

The annual report has many sections that contain useful information about the

company. One has to be careful while going through the annual report as there is a

very thin line between the facts presented by the company and the marketing

content that the company wants you to read.

Let us briefly go through the various sections of an annual report and understand

what the company is trying to communicate in the AR. For the sake of illustration, I

have taken the Annual Report of Amara Raja Batteries Limited, belonging to

Financial Year 2013-2014. As you may know Amara Raja Batteries Limited

manufactures automobile and industrial batteries. You can download ARBL’s FY2014

AR from here (http://www.amararaja.co.in/annual_reports.asp)

Please remember, the objective of this chapter is to give you a brief orientation on

how to read an annual report. Running through each and every page of an AR is not

practical; however, I would like to share some insights into how I would personally

read through an AR, and also help you understand what kind of information is

required and what information we can ignore.

For a better understanding, I would urge you to download the Annual Report of

ARBL and go through it simultaneously as we progress through this chapter.

ARBL’s annual report contains the following 9 sections:

o Financial Highlights

o The Management Statement

o Management Discussion & Analysis

o 10 year Financial highlights

o Corporate Information

o Director’s Report

o Report on Corporate governance

o Financial Section, and

o Notice

Note, no two annual reports are the same; they are all made to suite the company’s

requirement keeping in perspective the industry they operate in. However, some of

the sections in the annual report are common across annual reports.

The first section in ARBL’s AR is the Financial Highlights. Financial Highlights

contains the bird’s eye view on how the financials of the company looks for the year

gone by. . The information in this section can be in the form of a table or a graphical

display of data. This section of the annual report generally does a multi-year

comparison of the operating and business metrics.

Here is the snapshot of the same:

The details that you see in the Financial Highlights section are basically an extract

from the company’s financial statement. Along with the extracts, the company can

also include a few financial ratios, which are calculated by the company itself. I

briefly look through this section to get an overall idea, but I do not like to spend too

much time on it. The reason for looking at this section briefly is that, I would anyway

calculate these and many other ratios myself and while I do so, I would gain greater

clarity on the company and its numbers. Needless to say, over the next few chapters

we will understand how to read and understand the financial statements of the

company and also how to calculate the financial ratios.

The next two sections i.e the ‘Management Statement’ and ‘Management

Discussion & Analysis’ are quite important. I spend time going through these

sections. Both these sections gives you a sense on what the management of the

company has to say about their business and the industry in general. As an investor

or as a potential investor in the company, every word mentioned in these sections is

important. In fact some of the details related to the ‘Qualitative aspects’ (as

discussed in chapter 2), can be found in these two sections of the AR.

In the ‘Management Statement’ (sometimes called the Chairman’s Message), the

investor gets a perspective of how the man sitting right on top is thinking about his

business. The content here is usually broad based and gives a sense on how the

business is positioned. When I read through this section, I look at how realistic the

management is. I am very keen to see if the company’s management has its feet on

the ground. I also observe if they are transparent on discussing details on what

went right and what went wrong for the business.

One example that I explicitly remember was reading through the chairman’s

message of a well established tea manufacturing company. In his message, the

chairman was talking about a revenue growth of nearly 10%, however the historical

revenue numbers suggested that the company’s revenue was growing at a rate of 4-

5%. Clearly in this context, the growth rate of 10% seemed like a celestial move. This

also indicated to me that the man on top may not really be in sync with ground

reality and hence I decided not to invest in the company. Retrospectively when I

look back at my decision not to invest, it was probably the right decision.

Here is the snapshot of Amara Raja Batteries Limited; I have highlighted a small part

that I think is interesting. I would encourage you to read through the entire message

in the Annual Report.

Moving ahead, the next section is the ‘Management Discussion & Analysis’ or

‘MD&A’. This according to me is perhaps one of the most important sections in the

whole of AR. The most standard way for any company to start this section is by

talking about the macro trends in the economy. They discuss the overall economic

activity of the country and the business sentiment across the corporate world. If the

company has high exposure to exports, they even talk about global economic and

business sentiment.

ARBL has both exports and domestic business interest; hence they discuss both

these angles in their AR. See the snapshot below:

ARBL’s view on the Indian economy:

Following this the companies usually talk about the trends in the industry and what

they expect for the year ahead. This is an important section as we can understand

what the company perceives as threats and opportunities in the industry. Most

importantly I read through this, and also compare it with its peers to understand if

the company has any advantage over its peers.

For example, if Amara Raja Batteries limited is a company of interest to me, I would

read through this part of the AR and also would read through what Exide Batteries

Limited has to say in their AR.

Remember until this point the discussion in the Management Discussion & Analysis

is broad based and generic (global economy, domestic economy, and industry

trends). However going forward, the company would discuss various aspects related

to its business. It talks about how the business had performed across various

divisions, how did it fare in comparison to the previous year etc. The company in

fact gives out specific numbers in this section.

Here is a snapshot of the same:

Some companies even discuss their guidelines and strategies for the year ahead

across the various verticals they operate in. Do have a look at the snapshot below:

After discussing these in ‘Management Discussion & Analysis’ the annual report

includes a series of other reports such as – Human Resources report, R&D report,

Technology report etc. Each of these reports are important in the context of the

industry the company operates in. For example, if I am reading through a

manufacturing company annual report, I would be particularly interested in the

human resources report to understand if the company has any labor issues. If there

are serious signs of labor issues then it could potentially lead to the factory being

shut down, which is not good for the company’s shareholders.

3.3 – The Financial Statements

Finally, the last section of the AR contains the financial statements of the company.

As you would agree, the financial statements are perhaps one of the most

important aspects of an Annual Report. There are three financial statements that

the company will present namely:

1. The Profit and Loss statement

2. The Balance Sheet and

3. The Cash flow statement

We will understand each of these statements in detail over the next few chapters.

However at this stage it is important to understand that the financial statements

come in two forms.

1. Standalone financial statement or simply standalone numbers and

2. Consolidated financial statement or simply consolidated numbers

To understand the difference between standalone and consolidated numbers, we

need to understand the structure of a company.

Typically, a well established company has many subsidiaries. These companies also

act as a holding company for several other well established companies. To help you

understand this better, I have taken the example of CRISIL Limited’s shareholding

structure. You can find the same in CRISIL’s annual report. As you may know, CRISIL

is an Indian company with a major focus on corporate credit rating services.

As you can see in the above share holding structure:

1. Standard & Poor’s (S&P), a US based rating agency holds a 51% stake in CRISIL.

Hence S&P is the ‘Holding company’ or the ‘Promoter’ of CRISIL

2. The balance 49% of shares of CRISIL is held by Public and other Financial institutions

3. However, S&P itself is 100% subsidiary of another company called ‘The McGraw-Hill

Companies’

1. This means McGraw Hill fully owns S&P, and S&P owns 51% of CRISIL

4. Further, CRISIL itself fully owns (100% shareholding) another company called

‘Irevna’.

Keeping the above in perspective, think about this hypothetical situation. Assume,

for the financial year 2014, CRISIL makes a loss of Rs.1000 Crs and Irevna, its 100%

subsidiary makes a profit of Rs.700 Crs. What do you would be the overall

profitability of CRISIL?

Well, this is quite simple – CRISIL on its own made a loss of Rs.1000 Crs, but its

subsidiary Irevna made a profit of Rs.700 Crs, hence the overall P&L of CRISIL is

(Rs.1000 Crs) + Rs.700 Crs = (Rs.300 Crs).

Thanks to its subsidiary, CRISIL’s loss is reduced to Rs.300 Crs as opposed to a

massive loss of Rs.1000 Crs. Another way to look at it is, CRISIL on

a standalone basis made a loss of Rs.1000 Crs, but on a consolidated basis made a

loss of Rs.300 Crs.

Hence, Standalone Financial statements represent the standalone numbers/

financials of the company itself and do not include the financials of its subsidiaries.

However the consolidated numbers includes the companies (i.e.standalone

financials) and its subsidiaries financial statements.

I personally prefer to look through the consolidated financial statements as it gives

a better representation of the company’s financial position.

3.4 – Schedules of Financial Statements

When the company reports its financial statements, they usually report the full

statement in the beginning and then follow it up with a detailed explanation.

Have a look at the snapshot of one of ARBL’s financial statement (balance sheet):

Each particular in the financial statement is referred to as the line item. For example

the first line item in the Balance Sheet (under Equity and Liability) is the share

capital (as pointed out by the green arrow). If you notice, there is a note number

associated with share capital. These are called the ‘Schedules’ related to the

financial statement. Looking into the above statement, ARBL states that the share

capital stands at Rs.17.081 Crs (or Rs.170.81 Million). As an investor I obviously

would be interested to know how ARBL arrived at Rs.17.081 Crs as their share

capital. To figure this out, one needs to look into the associated schedule (note

number 2). Please look at the snapshot below:

Of course, considering you may be new to financial statements, jargon’s like share

capital make not make much sense. However the financial statements are extremely

simple to understand, and over the next few chapters you will understand how to

read the financial statements and make sense of it. But for now do remember that

the main financial statement gives you the summary and the associated schedules

give the details pertaining to each line item.

Key takeaways from this chapter

1. The Annual Report (AR) of a company is an official communication from the

company to its investors and other stakeholders

2. The AR is the best source to get information about the company; hence AR should

be the default choice for the investor to source company related information

3. The AR contains many sections, with each section highlighting certain aspect of the

business

4. The AR is also the best source to get information related to the qualitative aspects of

the company

5. The management discussion and analysis is one of the most important sections in

the AR. It has the management’s perspective on the overall economy of the country,

their outlook on the industry they operate in for the year gone by (what went right

and what went wrong), and what they foresee for the year ahead

6. The AR contains three financial statements – Profit & Loss statement, Balance Sheet,

and Cash Flow statement

7. The standalone statement contains the financial numbers of only the company in

consideration. However the consolidated numbers contains the company and its

subsidiaries financial numbers.

Module 3 — Fundamental Analysis

Chapter 4

Understanding the P&L Statement (Part

4.1 – Overview of the financial statements

You can think about the financial statements from two different angles:

1. From the maker’s perspective

2. From the user’s perspective

A maker prepares the financial statements. He is typically a person with an

accounting background. His job involves preparing ledger entries, matching bills and

receipts, tallying the inflows versus the outflows, auditing etc. The final objective of

the is to prepare transparent financial statements which best represents the true

financial position of the company. To prepare such a financial statement certain

skills are required, usually these skills are developed through the rigor of a

Chartered Accountant’s training program.

The user on the other hand just needs to be in a position to understand what the

maker has prepared. He is just the user of the financial statements. He need not

really know the details of the journal entries or the audit procedure. His main

concern is to read what is being stated and use it to make his decisions.

To put this in context, think about Google. Most of us do not understand Google’s

complex search engine algorithm that runs in the backend, however we all know

how to use Google effectively. Such is the distinction between the maker and the

user of financial statements.

A common misconception amongst the market participants is that, they believe the

fundamental analyst needs to be thorough with concepts of financial statement

preparation. While knowing this certainly helps, it is not really required. To be a

fundamental analyst, one just needs to be the user and not the maker of the

financial statements.

There are three main financial statements that a company showcases to represent

its performance.

1. The Profit and Loss statement

2. The Balance Sheet

3. The Cash flow statement

Over the next few chapters we will understand each of these statements from the

user’s perspective.

4.2 – The Profit and Loss statement

The Profit and Loss statement is also popularly referred to as the P&L statement,

Income Statement, Statement of Operations, and Statement of Earnings. The Profit

and Loss statement shows what has transpired during a time period. The P&L

statement reports information on:

1. The revenue of the company for the given period (yearly or quarterly)

2. The expenses incurred to generate the revenues

3. Tax and depreciation

4. The earnings per share number

From my experience, the financial statements are best understood by looking at the

actual statement and figuring out the information. Hence, here is the P&L statement

of Amara Raja Batteries Limited (ARBL). Let us understand each and every line item.

4.3 – The Top Line of the company (Revenue)

You may have heard analysts talk about the top line of a company. When they do

so, they are referring to the revenue side of the P&L statement. The revenue side is

the first set of numbers the company presents in the P&L.

Before we start understanding the revenue side, let us notice a few things

mentioned on the header of the P&L statement:

The header clearly states:

1. The statement of P&L for the year ending March 31, 2014, hence this is an annual

statement and not a quarterly statement. Also, since it is as of March 31

2014 it is

evident that the statement is for the Financial Year 2013 – 2014 or simply it can be

referred to as the FY14 numbers

2. All currency is denominated in Rupee Million. Note – 1 Million Rupees is equal to

Ten Lakh Rupees. It is upto the company’s discretion to decide which unit they

would prefer to express their numbers in

3. The particulars show all the main headings of the statement. Any associated note to

the particulars is present in the note section (also called the schedule). An

associated number is assigned to the note (Note Number)

4. By default when companies report the numbers in the financial statement they

present the current year number on the left most column and the previous year

number to the right. In this case the numbers are for FY14 (latest) and FY13

(previous)

The first line item on the revenue side is called the Sale of Products.

Since we know we are dealing with a batteries company, clearly sale of products

means the Rupee value of all the battery sales the company has sold during FY14.

The sales stand at Rs.38,041,270,000/- or about Rs.3,804 Crore. The company sold

batteries worth Rs.3,294 Cr in the previous financial year i.e FY13.

Please note, I will restate all the numbers in Rupee Crore as I believe this is more

intuitive to understand.

The next line item is the excise duty. This is the amount (Rs.400 Crs) the company

would pay to the government; hence the revenue has to be adjusted.

The revenue adjusted after the excise duty is the net sales of the company. The

net sales of ARBL is Rs.3403 Crs for FY14. The same was Rs.2943 Crs for FY13.

Apart from the sale of products, the company also draws revenue from services.

This could probably be in the form of annual battery maintenance. The revenue

from sale of services stands at Rs.30.9Crs for FY14.

The company also includes “other operating revenues” at Rs.2.1crs.This could be

revenues through the sale of products or services that is incidental to the core

operations of the company.

Finally the revenue from Sale of products + Sale of services + Other operating

revenues sums up to give the total operating revenue of the company. This is

reported at Rs.3436 Crs for FY14 and Rs.2959Crs for FY13. Interesting, there is a

note; numbered 17 associated with “Net Revenue from Operations” which will help

us inspect this aspect further.

Do recall, in the previous chapter we had discussed about notes and schedules of

the financial statement.

The following snapshot gives the details of note 17.

Clearly, the notes give a more detailed analysis of the split up of revenues from

operations (does not include other income details). As you can see under the

particulars, section ‘a’ talks about the split up under sales of products.

1. Sale of storage batteries in the form of finished goods for the year FY14 is Rs.3523

Crs versus Rs.3036 Crs in FY13

2. Sale of Storage batteries (stock in trade) is Rs.208 Crs in FY14 versus 149 Crs. Stock

in trade refers to finished goods of previous financial year being sold in this financial

year

3. Sale of home UPS (stock in goods) is at Rs.71 Crs in FY14 versus Rs.109 Crs FY13

4. Net sales from sales of products adjusted for excise duty amounts to Rs.3403 Crs,

which matches with the number reported in the P&L statement

5. Likewise you can notice the split up for revenue from services. The revenue number

of Rs.30.9 tallies with number reported in the P&L statement

6. In the note, the company says the “Sale of Process Scrap” generated revenue of

Rs.2.1 Cr. Note that the sale of process scrap is incidental to the operations of the

company, hence reported as ‘Other operating revenue”.

7. Adding up all the revenue streams of the company i.e Rs.3403 Crs+ Rs.30.9 Crs

+Rs.2.1 Crs gets us the Net revenue from operations = Rs.3436 Crs.

8. You can also find similar split up for FY13

If you notice the P&L statement, apart from net revenue from operations ARBL also

reports ‘Other Income’ of Rs.45.5 Crs. Note number 18 reproduced below explains

what the other income is all about.

As we can see the other income includes income that is not related to the main

business of the company. It includes interest on bank deposits, dividends, insurance

claims, royalty income etc. Usually the other income forms (and it should) a small

portion of the total income. A large ‘other income’ usually draws a red flag and it

would demand a further investigation.

So adding up revenue from operations (Rs.3436 Crs) and other income (Rs.45 Crs),

we have the total revenue of for FY14 at Rs.3482Crs.

Key takeaways from this chapter

1. The financial statement provides information and conveys the financial position of

the company

2. A complete set of financial statements include the Profit & Loss Account, Balance

Sheet and Cash Flow Statement

3. A fundamental Analyst is a user of financial statement, and he just needs to know

what the maker of the financial statements states

4. The profit and loss statement gives the profitability of the company for the year

under consideration

5. The P&L statement is an estimate, as the company can revise the numbers at a later

point. Also by default companies publish data for the current year and the previous

year, side by side

6. The revenue side of the P&L is also called the top line of the company

7. Revenue from operations is the main source of revenue for the company

8. Other operating income includes revenue incidental to the business

9. The other income includes revenue from non operating sources

10. The sum of revenue from operations (net of duty), other operating income, and

other incomes gives the ‘Net Revenue from Operations’

Module 3 — Fundamental Analysis

Chapter 5

Understanding P&L Statement (Part 2)

121

5.1 – The Expense details

In the previous chapter we had learnt about the revenues a company generates.

Moving further on the P&L statement, in this chapter we will look at the expense

side of the Profit and Loss Statement along with the associated notes. Expenses are

generally classified according to their function, which is also called the cost of sales

method or based on the nature of expense. An analysis of the expenses must be

shown in the Profit and Loss statement or in the notes. As you can see in the extract

below almost all the line items have a note associated to it.

The first line item on the expense side is ‘Cost of materials consumed’; this is

invariably the cost of raw material that the company requires to manufacture

finished goods. As you can see the cost of raw material consumed/raw material is

the largest expense incurred by the company. This expense stands at Rs.2101 Crs

for the FY14 and Rs.1760 Crs for the FY13. Note number 19 gives the associated

details for this expense, let us inspect the same.

As you can see note 19 gives us the details of the material consumed. The company

uses lead, lead alloys, separators and other items all of which adds up to Rs.2101

Crs.

The next two line items talks about ‘Purchases of Stock in Trade’ and ‘Change in

Inventories of finished goods , work–in-process & stock–in-trade’. Both these line

items are associated with the same note (Note 20).

Purchases of stock in trade, refers to all the purchases of finished goods that the

company buys towards conducting its business. This stands at Rs.211 Crs. I will give

you more clarity on this line item shortly.

Change in inventory of finished goods refers to the costs of manufacturing incurred

by the company in the past , but the goods manufactured in the past were sold in

the present/current financial year. This stands at (Rs.29.2) Crs for the FY14.

A negative number indicates that the company produced more batteries in the FY14

than it managed to sell. To give a sense of proportion (in terms of sales and costs of

sales) the company deducts the cost incurred in manufacturing the extra goods

from the current year costs. The company will add this cost when they manage to

sell these extra products sometime in future. This cost, which the company adds

back later, will be included in the “Purchases of Stock in Trade” line item.

Here is an extract of Note 20 which details the above two line items:

The details mentioned on the above extract are quite straightforward and is easy to

understand. At this stage it may not be necessary to dig deeper into this note. It is

good to know where the grand total lies. However, when we take up ‘Financial

Modeling’ as a separate module we will delve deeper into this aspect.

The next line item on the expense side is “Employee Benefit Expense”. This is quite

intuitive as it includes expense incurred in terms of the salaries paid, contribution

towards provident funds, and other employee welfare expenses. This stands at

Rs.158 Crs for the FY14. Have a look at the extract of note 21 which details the

‘Employee Benefit Expense’.

Here is something for you to think about – A company generating Rs.3482 Crs is

spending only Rs.158 Crs or just 4.5% of its sales on its employees. In fact this is the

pattern across most of companies (at least non IT). Perhaps it is time for you to

rethink about that entrepreneurial dream you may have nurtured.

The next line item is the “Finance Cost / Finance Charges/ Borrowing Costs”. Finance

cost is interest costs and other costs that an entity pays when it borrows funds. The

interest is paid to the lenders of the company. The lenders could be banks or private

lenders. The company’s finance cost stands at Rs.0.7 Crs for the FY14. We will

discuss more about the debt and related matters when we take up the chapter on

the balance sheet later.

Following the finance cost the next line item is “Depreciation and Amortization”

costs which stand at Rs.64.5 Crs. To understand depreciation and amortization we

need to understand the concept of tangible and intangible assets.

A tangible asset is one which has a physical form and provides an economic value to

the company. For example a laptop, a printer, a car, plants, machinery, buildings etc.

An intangible asset is something that does not have a physical form but still

provides an economic value to the company such as brand value, trademarks,

copyrights, patents, franchises, customer lists etc.

An asset (tangible or intangible) has to be depreciated over its useful life. Useful life

is defined as the period during which the asset can provide economic benefit to the

company. For example the useful life of a laptop could be 4 years. Let us

understand depreciation better with the help of the following example.

Zerodha, a stock broking firm generates Rs.100,000/- from the stock broking

business. However Zerodha incurred an expense of Rs.65,000/- towards the

purchase of a high performance computer server. The economic life (useful life) of

the server is expected to be 5 years. Now if you were to look into the earning

capability of Zerodha it appears that on one hand Zerodha earned Rs.100,000/- and

on the other hand spent Rs.65,000/- and therefore retained just Rs.35,000/-. This

skews the earnings data for the current year and does not really reflect the true

earning capability of the company.

Remember the asset even though purchased this year, would continue to provide

economic benefits over its useful life. Hence it makes sense to spread the cost of

acquiring the asset over its useful life. This is called depreciation. This means

instead of showing an upfront lump sum expense (towards purchase of an asset),

the company can show a smaller amount spread across the useful life of an asset.

Thus Rs.65,000/- will be spread across the useful life of the server, which is 5. Hence

65,000/ 5 = Rs.13,000/- would be depreciated every year over the next five years. By

depreciating the asset, we are spreading the upfront cost. Hence after the

depreciation computation, Zerodha would now show its earrings as Rs.100,000 –

Rs.13,000 = Rs.87,000/-.

We can do a similar exercise for non tangible assets. The depreciation equivalent for

non tangible assets is called amortization.

Now here is an important idea – Zerodha depreciates the cost of acquiring an asset

over its useful life. However, in reality there is an actual outflow of Rs.65,000/- paid

towards the asset purchase. But now, it seems like the P&L is not capturing this

outflow. As an analyst, how do we get a sense of the cash movement? Well, the cash

movement is captured in the cash flow statement, which we will understand in the

later chapters.

Here is the snapshot of Note 23, detailing the depreciation cost.

The last line item on the expense side is “other expenses” at Rs.434.6 Crs. This is a

huge amount classified under ‘other expenses’, hence it deserves a detailed

inspection.

From the note it is quite clear that other expenses include manufacturing, selling,

administrative and other expenses. The details are mentioned in the note. For

example, Amara Raja Batteries Limited (ARBL) spent Rs.27.5 Crs on advertisement

and promotional activities.

Adding up all the expenses mentioned in the expense side of P&L, it seems that

Amara Raja Batteries has spent Rs.2941.6 Crs.

5.2 – The Profit before tax

It refers to the net operating income after deducting operating expenses but before

deducting taxes and interest. Proceeding further on the P&L statement we can see

that ARBL has mentioned their profit before tax and exceptional item numbers.

Simply put the profit before tax (PBT) is:

Profit before Tax = Total Revenues – Total Operating Expenses

= Rs.3482 – Rs.2941.6

=Rs.540.5

However there seems to be an exceptional item/ extraordinary item of Rs.3.8 Crs,

which needs to be deducted. Exceptional items/ extraordinary items are expenses

occurring at one odd time for the company and the company does not foresee this

as a recurring expense. Hence they treat it separately on the P&L statement.

Hence profit before tax and extraordinary items will be:

= 540.5 – 3.88

= Rs.536.6 Crs

The snapshot below (extract from P&L) shows the PBT(Profit Before Tax) of ARBL:

5.3 – Net Profit after tax

The net operating profit after tax is defined as the company’s operating profit after

deducting its tax liability. We are now looking into the last part of the P&L

statement, which is the profit after tax. This is also called the bottom line of the P&L

statement.

As you can see from the snapshot above, to arrive at the profit after tax (PAT) we

need to deduct all the applicable tax expenses from the PBT. Current tax is the

corporate tax applicable for the given year. This stands at Rs.158 Crs. Besides this,

there are other taxes that the company has paid. All taxes together total upto

Rs.169.21 Crs. Deducting the tax amount from the PBT of Rs.536.6 gives us the

profit after tax (PAT) at Rs.367.4 Crs.

Hence Net PAT = PBT – Applicable taxes.

The last line in the P&L statement talks about basic and diluted earnings per share.

The EPS is one of the most frequently used statistics in financial analysis. EPS also

serves as a means to assess the stewardship and management role performed by

the company directors and managers. The earnings per share (EPS) is a very sacred

number which indicates how much the company is earning per face value of the

ordinary share. It appears that ARBL is earning Rs.21.51 per share. The detailed

calculation is as shown below:

The company indicates that there are 17,08,12,500 shares outstanding in the

market. Dividing the total profit after tax number by the outstanding number of

shares, we can arrive at the earnings per share number. In this case:

Rs.367.4 Crs divided by 17,08,12,500 yields Rs.21.5 per share.

5.4 – Conclusion

Now that we have gone through all the line items in the P&L statement let us relook

at it in its entirety.

Hopefully, the statement above should look more meaningful to you by now.

Remember almost all line items in the P&L statement will have an associated note.

You can always look into the notes to seek greater clarity. Also at this stage we have

just understood how to read the P&L statement, but we still need to analyze what

the numbers mean. We will do this when we take up the financial ratios. Also, the

P&L statement is very closely connected with the other two financial statements i.e

the balance sheet and the cash flow statement. We will explore these connections at

a later stage.

Key takeaways from this chapter:

1. The expense part of the P&L statement contains information on all the expenses

incurred by the company during the financial year

2. Each expense can be studied with reference to a note which you can explore for

further information

3. Depreciation and amortization is way of spreading the cost of an asset over its

useful life

4. Finance cost is the cost of interest and other charges paid when the company

borrows money for its capital expenditure.

5. PBT = Total Revenue – Total Expense – Exceptional items (if any)

6. Net PAT = PBT – applicable taxes

7. EPS reflects the earning capacity of a company on a per share basis. Earnings are

profit after tax and preferred dividends.

8. EPS = PAT / Total number of outstanding ordinary shares

Module 3 — Fundamental Analysis

Chapter 6

Understanding Balance Sheet Statement

(Part 1)

132

6.1 – The balance sheet equation

While the P&L statement gives us information pertaining to the profitability of the

company, the balance sheet gives us information pertaining to the assets, liabilities,

and the shareholders equity. The P&L statement as you understood, discusses

about the profitability for the financial year under consideration, hence it is good to

say that the P&L statement is a standalone statement. The balance sheet however is

prepared on a flow basis, meaning, it has financial information pertaining to the

company right from the time it was incorporated. Thus while the P&L talks about

how the company performed in a particular financial year; the balance sheet on the

other hand discusses how the company has evolved financially over the years.

Have a look at the balance sheet of Amara Raja Batteries Limited (ARBL):

As you can see the balance sheet contains details about the assets, liabilities, and

equity.

We had discussed about assets in the previous chapter. Assets, both tangible and

intangible are owned by the company. An asset is a resource controlled by the

company, and is expected to have an economic value in the future. Typical

examples of assets include plants, machinery, cash, brands, patents etc. Assets are

of two types, current and non-current, we will discuss these later in the chapter.

Liability on the other hand represents the company’s obligation. The obligation is

taken up by the company because the company believes these obligations will

provide economic value in the long run. Liability in simple words is the loan that the

company has taken and it is therefore obligated to repay back. Typical examples of

obligation include short term borrowing, long term borrowing, payments due etc.

Liabilities are of two types namely current and non-current. We will discuss about

the kinds of liabilities later on in the chapter.

In any typical balance sheet, the total assets of company should be equal to the

total liabilities of the company. Hence,

Assets = Liabilities

The equation above is called the balance sheet equation or the accounting

equation. In fact this equation depicts the key property of the balance sheet i.e the

balance sheet should always be balanced. In other word the Assets of the company

should be equal to the Liabilities of the company. This is because everything that a

company owns (Assets) has to be purchased either from either the owner’s capital

or liabilities.

Owners Capital is the difference between the Assets and Liabilities. It is also called

the ‘Shareholders Equity’ or the ‘Net worth’. Representing this in the form of an

equation :

Share holders equity = Assets – Liabilities

6.2 –A quick note on shareholders’ funds

As we know the balance sheet has two main sections i.e. the assets and the

liabilities. The liabilities as you know represent the obligation of the company. The

shareholders’ fund, which is integral to the liabilities side of the balance sheet, is

highlighted in the snapshot below. Many people find this term a little confusing.

If you think about it, on one hand we are discussing about liabilities which represent

the obligation of the company, and on the other hand we are discussing the

shareholders’ fund which represents the shareholders’ wealth. This is quite counter

intuitive isn’t it? How can liabilities and shareholders’ funds appear on the ‘Liabilities’

side of balance sheet? After all the shareholders funds represents the funds

belonging to its shareholders’ which in the true sense is an asset and not really a

liability.

To make sense of this, you should change the perceptive in which you look at a

company’s financial statement. Think about the entire company as an individual,

whose sole job is run its core operation and to create wealth to its shareholders’. By

thinking this way, you are in fact separating out the shareholders’ (which also

includes its promoters) and the company. With this new perspective, now think

about the financial statement. You will appreciate that, the financial statements is a

statement published by the company (which is an entity on its own) to communicate

to the world about its financial well being.

This also means the shareholders’ funds do not belong to the company as it

rightfully belongs to the company’s shareholders’. Hence from the company’s

perspective the shareholders’ funds are an obligation payable to shareholders’.

Hence this is shown on the liabilities side of the balance sheet.

6.3 –The liability side of balance sheet

The liabilities side of the balance sheet details out all the liabilities of the company.

Within liabilities there are three sub sections – shareholders’ fund, non-current

liabilities, and current liabilities. The first section is the shareholders’ funds.

To understand share capital, think about a fictional company issuing shares for the

first time. Imagine, Company ABC issues 1000 shares, with each share having a face

value of Rs.10 each. The share capital in this case would be Rs.10 x 1000 =

Rs.10,000/- (Face value X number of shares).

In the case of ARBL, the share capital is Rs.17.081 Crs (as published in the Balance

Sheet) and the Face Value is Rs.1/-. I got the FV value from the NSE’s website:

I can use the FV and share capital value to calculate the number of shares

outstanding. We know:

Share Capital = FV * Number of shares

Therefore,

Number of shares = Share Capital / FV

Hence in case of ARBL,

Number of shares = 17,08,10,000 / 1

= 17,08,10,000 shares

The next line item on the liability side of the Balance Sheet is the ‘Reserves and

Surplus’. Reserves are usually money earmarked by the company for specific

purposes. Surplus is where all the profits of the company reside. The reserves and

surplus for ARBL stands at Rs.1,345.6 Crs. The reserves and surplus have an

associated note, numbered 3. Let us look into the same.

As you can notice from the note, the company has earmarked funds across three

kinds of reserves:

1. Capital reserves – Usually earmarked for long term projects. Clearly ARBL does not

have much amount here. This amount belongs to the shareholders, but cannot be

distributed to them.

2. Securities premium reserve / account – This is where the premium over and

above the face/par value of the shares sits. ARBL has a Rs.31.18 Crs under this

reserve

3. General reserve – This is where all the accumulated profits of the company which is

not yet distributed to the shareholder reside. The company can use the money here

as a buffer. As you can see ARBL has Rs.218.4 Crs in general reserves.

The next section deals with the surplus. As mentioned earlier, surplus holds the

profits made during the year. Couple of interesting things to note:

1. As per the last year (FY13) balance sheet the surplus was Rs.829.8Crs. This is what is stated as

the opening line under surplus. See the image below:

1. The current year (FY14) profit of Rs.367.4 Crs is added to previous years closing

balance of surplus. Few things to take note here:

1. Notice how the bottom line of P&L is interacting with the balance sheet. This highlights a very

important fact – all the three financial statements are closely related

2. Notice how the previous year balance sheet number is added up to this year’s number. This

highlights the fact that the balance sheet is prepared on a flow basis, adding the carrying

forward numbers year on year

2. Previous year’s balance plus this year’s profit adds up to Rs.1197.2 Crs. The

company can choose to apportion this money for various purposes.

1. The first thing a company does is it transfers some money from the surplus to general reserves

so that it will come handy for future use. They have transferred close to Rs.36.7 Crs for this

purpose

2. After transferring to general reserves they have distributed Rs.55.1 Crs as dividends over which

they have to pay Rs.9.3 Crs as dividend distribution taxes.

3. After making the necessary apportions the company has Rs.1095.9 Crs as surplus as

closing balance. This as you may have guessed will be the opening balance for next

year’s (FY15) surplus account.

4. Total Reserves and Surplus = Capital reserve + securities premium reserve + general

reserves + surplus for the year. This stands at Rs.1345.6 Crs for the FY 14 against

Rs.1042.7 Crs for the FY13

The total shareholders’ fund is a sum of share capital and reserves & surplus. Since

this amount on the liability side of the balance sheet represents the money

belonging to shareholders’, this is called the ‘shareholders funds’.

6.4 – Non Current Liabilities

Non-current liabilities represent the long term obligations, which the company

intends to settle/ pay off not within 365 days/ 12 months of the balance sheet date.

These obligations stay on the books for few years. Non-current liabilities are

generally settled after 12 months after the reporting period.

Here is the snapshot of the non-current liabilities of Amara Raja batteries Ltd.

The company has three types of non-current liabilities; let us inspect each one of

them.

The long term borrowing (associated with note 4) is the first line item within the

non-current liabilities. Long term borrowing is one of the most important line item

in the entire balance sheet as it represents the amount of money that the company

has borrowed through various sources. Long term borrowing is also one of the key

inputs while calculating some of the financial ratios. Subsequently in this module we

will look into the financial ratios.

Let us look into the note associated with ‘Long term borrowings’:

From the note it is quite clear that the ‘Long term borrowings’ is in the form of

‘interest free sales tax deferment’. To understand what interest free sales tax

deferment really means, the company has explained just below the note (I have

highlighted the same in a red box). It appears to be some sort of tax incentive from

the state government. The company plans to settle this amount over a period of 14

years.

You will find that there are many companies which do not have long term

borrowings (debt). While it is a good to know that the company has no debt, you

must also question as to why there is no debt? Is it because the banks are refusing

to lend to the company? or is it because the company is not taking initiatives to

expand their business operations. Of course, we will deal with the analysis part of

the balance sheet later in the module.

Do recollect, we looked at ‘Finance Cost’ as a line item when we looked at the P&L

statement. If the debt of the company is high, then the finance cost will also be high.

The next line item within the non-current liability is ‘Deferred Tax Liability’. The

deferred tax liability is basically a provision for future tax payments. The company

foresees a situation where it may have to pay additional taxes in the future; hence

they set aside some funds for this purpose. Why do you think the company would

put itself in a situation where it has to pay more taxes for the current year at some

point in the future?

Well this happens because of the difference in the way depreciation is treated as

per Company’s act and Income tax. We will not get into this aspect as we will digress

from our objective of becoming users of financial statements. But do remember,

deferred tax liability arises due to the treatment of depreciation.

The last line item within the non-current liability is the ‘Long term provisions’. Long

term provisions are usually money set aside for employee benefits such as gratuity;

leave encashment, provident funds etc.

6.5 – Current liabilities

Current liabilities are a company’s obligations which are expected to be settled

within 365 days (less than 1 year). The term ‘Current’ is used to indicate that the

obligation is going to be settled soon, within a year. Going by that ‘non-current’

clearly means obligations that extend beyond 365 days.

Think about this way – if you buy a mobile phone on EMI (via a credit card) you

obviously plan to repay your credit card company within a few months. This

becomes your ‘current liability’. However if you buy an apartment by seeking a 15

year home loan from a housing finance company, it becomes your ‘non-current

liability’.

Here is the snapshot of ARBL’s current liabilities:

As you can see there are 4 line items within the current liabilities. The first one is the

short term borrowings. As the name suggests, these are short term obligations of

the company usually undertaken by the company to meet day to day cash

requirements (also called working capital requirements). Here is the extract of note

7, which details what short term borrowings mean:

Clearly as you can see, these are short term loans availed from the State bank of

India and Andhra Bank towards meeting the working capital requirements. It is

interesting to note that the short term borrowing is also kept at low level, at just

Rs.8.3Crs.

The next line item is Trade Payable (also called account payable) which is at Rs.127.7

Crs. These are obligations payable to vendors who supply to the company. The

vendors could be raw material suppliers, utility companies providing services,

stationary companies etc. Have a look at note 8 which gives the details:

The next line item just says ‘Other current liabilities’ which stands at Rs.215.6 Crs.

Usually ‘Other current Liabilities’ are obligations associated with the statutory

requirements and obligations that are not directly related to the operations of the

company. Here is note 9 associated with ‘Other current liabilities’:

The last line item in current liabilities is the ‘Short term provisions’ which stands at

Rs.281.8 Crs. Short term provisions is quite similar to long term provisions, both of

which deals with setting aside funds for employee benefits such as gratuity, leave

encashment, provident funds etc. Interestingly the note associated with ‘Short term

Provisions’ and the ‘Long term provisions’ is the same. Have a look at the following:

Since note 6 is detailing both long and short term provisions it runs into several

pages, hence for this reason I will not represent an extract of it. For those who are

curious to look into the same can refer to pages 80, 81, 82 and 83 in the FY14

Annual report for Amara Raja Batteries Limited.

However, from the user of a financial statement perspective all you need to know is

that these line items (short and long term provisions) deal with the employee and

related benefits. Please note, one should always look at the associated note to run

through the details.

We have now looked through half of the balance sheet which is broadly classified as

the Liabilities side of the Balance sheet. Let us relook at the balance sheet once

again to get a perspective:

Clearly,

Total Liability = Shareholders’ Funds + Non Current Liabilities + Current

Liabilities

= 1362.7 + 143.03 + 633.7

Total Liability = Rs.2139.4 Crs

Key takeaways from this chapter

1. A Balance sheet also called the Statement of Financial Position is prepared on a flow

basis which depicts the financial position of the company at any given point in time.

It is a statement which shows what the company owns ( assets) and what the

company owes (liabilities)

2. A business will generally need a balance sheet when it seeks investors, applies for

loans, submits taxes etc.

3. Balance sheet equation is Assets = Liabilities + Shareholders’ Equity

4. Liabilities are obligations or debts of a business from past transactions and Share

capital is number of shares * face value

5. Reserves are the funds earmarked for a specific purpose, which the company

intends to use in future

6. Surplus is where the profits of the company reside. This is one of the points where

the balance sheet and the P&L interact. Dividends are paid out of the surplus

7. Shareholders’ equity = Share capital + Reserves + Surplus. Equity is the claim of the

owners on the assets of the company. It represents the assets that remain after

deducting the liabilities. If you rearrange the Balance Sheet equation, Equity =

Assets – Liabilities.

8. Non-current liabilities or the long term liabilities are obligations which are expected

to be settled in not less than 365 days or 12 months of the balance sheet date

9. Deferred tax liabilities arise due to the discrepancy in the way the depreciation is

treated. Deferred tax liabilities are amounts of income taxes payable in the future

with respect to taxable differences as per accounting books and tax books.

10. Current liabilities are the obligations the company plans to settle within 365 days

/12 months of the balance sheet date.

11. In most cases both long and short term provisions are liabilities dealing with

employee related matters

12. Total Liability = Shareholders’ Funds + Non Current Liabilities + Current Liabilities. .

Thus, total liabilities represent the total amount of money the company owes to

others

Module 3 — Fundamental Analysis

Chapter 7

Understanding the Balance Sheet

Statement (Part 2)

7.1 – The Assets side of Balance Sheet

In the previous chapter we looked at the liability side of the balance sheet in detail.

We will now proceed to understand the 2

half of the balance sheet i.e the Asset

side of the balance sheet. The Asset side shows us all the assets the company owns

(in different forms) right from its inception. Assets in simple terms are the resources

held by a company, which help in generating the revenues. Here is the snapshot of

the Assets side of the balance sheet:

As you can see the Asset side has two main sections i.e Non-current assets and

Current assets. Both these sections have several line items (with associated notes)

included within. We will look into each one of these line items.

7.2 – Non-current assets (Fixed Assets)

Similar to what we learnt in the previous chapter, non-current assets talks about the

assets that the company owns, the economic benefit of which is enjoyed over a long

period (beyond 365 days). Remember an asset owned by a company is expected to

give the company an economic benefit over its useful life.

If you notice within the non-current assets there is a subsection called “Fixed Assets”

with many line items under it. Fixed assets are assets (both tangible and intangible)

that the company owns which cannot be converted to cash easily or which cannot

be liquidated easily. Typical examples of fixed assets are land, plant and machinery,

vehicles, building etc. Intangible assets are also considered fixed assets because

they benefit companies over a long period of time. If you see, all the line items

within fixed assets have a common note, numbered 10, which we will explore in

great detail shortly.

Here is the snapshot of fixed assets of Amara Raja Batteries Limited:

The first line item ‘Tangible Assets’ is valued at Rs.619.8Crs. Tangible assets consists

of assets which has a physical form. In other words these assets can be seen or

touched. This usually includes plant and machinery, vehicles, buildings, fixtures etc.

Likewise the next line item reports the value of Intangible assets valued at Rs.3.2

Crs. Intangible assets are assets which have an economic value, but do not have a

physical nature. This usually includes patents, copyrights, trademarks, designs etc.

Remember when we discussed the P&L statement we discussed depreciation.

Depreciation is a way of spreading the cost of acquiring the asset over its useful life.

The value of the assets deplete over time, as the assets lose their productive

capacity due to obsolescence and physical wear and tear. This value is called the

Depreciation expense, which is shown in the Profit and Loss account and the

Balance Sheet.

All the assets should be depreciated over its useful life. Keeping this in perspective,

when the company acquires an asset it is called the ‘Gross Block’. Depreciation

should be deducted from the Gross block, after which we can arrive at the ‘Net

Block’.

Net Block = Gross Block –Accumulated Depreciation

Note, the term ‘Accumulated’ is used to indicate all the depreciation value since the

incorporation of the company.

When we read tangible assets at Rs.619.8 Crs and Intangible assets at Rs.3.2 Crs, do

remember the company is reporting its Net block, which is Net of Accumulated

depreciation. Have a look at the Note 10, which is associated with fixed assets.

At the top of the note you can see the Gross Block, Depreciation/amortization, and

Net block being highlighted. I have also highlighted two net block numbers which

tallies with what was mentioned in the balance sheet.

Let us look at a few more interesting aspects on this note. Notice under Tangible

assets you can see the list of all the assets the company owns.

For example, the company has listed ‘Buildings’ as one of its tangible asset. I have

highlighted this part:-

As of 31

March 2013 (FY13) ARBL reported the value of the building at Rs.93.4 Crs.

During the FY14 the company added Rs.85.8Crs worth of building, this amount is

classified as ‘additions during the year’. Further they also wound up 0.668 Crs worth

of building; this amount is classified as ‘deductions during the year’. Hence the

current year value of the building would be:

Previous year’s value of building + addition during this year – deduction during the

year

93.4 + 85.8 – 0.668

= 178.5Crs

You can notice this number being highlighted in blue in the above image. Do

remember this is the gross block of the building. From the gross block one needs to

deduct the accumulated depreciation to arrive at the ‘Net Block’. In the snapshot

below, I have highlighted the depreciation section belonging to the ‘Building’.

As of 31

March 2013 (FY13) ARBL has depreciated Rs.17.2 Crs, to which they need

to add Rs.2.8 Crs belonging to the year FY14, adjust 0.376 Crs as the deduction for

the year. Thus, the Total Depreciation for the year is:-

Previous year’s depreciation value + Current year’s depreciation – Deduction for the

year

= 17.2 + 2.8 – 0.376

Total Depreciation= Rs.19.736 Crs. This is highlighted in red in the image above.

So, we have building gross block at Rs.178.6 Crs and depreciation at Rs.19.73 Crs

which gives us a net block of Rs.158.8 Crs ( 178.6– 19.73). The same has been

highlighted in the image below:

The same exercise is carried out for all the other tangible and intangible assets to

arrive at the Total Net block number.

The next two line items under the fixed assets are Capital work in progress (CWIP)

and Intangible assets under development.

CWIP includes building under construction, machinery under assembly etc at the

time of preparing the balance sheet. Hence it is aptly called the “Capital Work in

Progress”. This amount is usually mentioned in the Net block section. CWIP is the

work that is not yet complete but where a capital expenditure has already been

incurred. As we can see, ARBL has Rs.144.3 Crs under CWIP. Once the construction

process is done and the asset is put to use, the asset is moved to tangible assets

(under fixed assets) from CWIP.

The last line item is ‘Intangible assets under development’. This is similar to CWIP

but for intangible assets. The work in process could be patent filing, copyright filing,

brand development etc. This is at a miniscule cost of 0.3 Crs for ARBL. All these costs

are added to arrive at the total fixed cost of the company.

7.3 – Non-current assets (Other line items)

Besides the fixed assets under the non-current assets, there are other line items as

well. Here is a snapshot for the same:

Non-current investments are investments made by ARBL with a long term

perspective. This stands at Rs.16.07 Crs. The investment could be anything – buying

listed equity shares, minority stake in other companies, debentures, mutual funds

etc. Here is the partial (as I could not fit the entire image) snapshot of Note 11. This

should give you a perspective.

The next line item is long term loans and advances which stand at Rs.56.7Crs. These

are loans and advances given out by the company to other group companies,

employees, suppliers, vendors etc.

The last line item under the Non-current assets is ‘Other Non-current assets’ which

is at Rs. 0.122 Crs. This includes other miscellaneous long term assets.

7.4 – Current assets

Current assets are assets that can be easily converted to cash and the company

foresees a situation of consuming these assets within 365 days. Current assets are

the assets that a company uses to fund its day to day operations and ongoing

expenses.

The most common current assets are cash and cash equivalents, inventories,

receivables, short term loans and advances and sundry debtors.

Here is the snapshot of the current assets of ARBL:

The first line item on the Current assets is Inventory which stands at Rs.335.0 Crs.

Inventory includes all the finished goods manufactured by the company, raw

materials in stock, goods that are manufactured incompletely etc. Inventories are

goods at various stages of production and hence have not been sold. When any

product is manufactured in a company it goes through various processes from raw

material, to work in progress to a finished good. Snapshot of Note 14 associated

with inventory of the company is as shown below:

As you can see, a bulk of the inventory value comes from ‘Raw material’ and ‘Work-

in- progress’.

The next line item is ‘Trade Receivables’ also referred to as ‘Accounts Receivables’.

This represents the amount of money that the company is expected to receive from

its distributors, customers and other related parties. The trade receivable for ARBL

stands at Rs.452.7 Crs.

The next line item is the Cash and Cash equivalents, which are considered the most

liquid assets found in the Balance sheet of any company. Cash comprises of cash on

hand and cash on demand. Cash equivalents are short term, highly liquid

investments which has a maturity date of less than three months from its

acquisition date. This stands at Rs.294.5 Crs. Note 16 associated with Cash and bank

balances is as shown below. As you can see the company has cash parked in various

types of accounts.

The next line item is short-term loans and advances, that the company has tendered

and which is expected to be repaid back to the company within 365 days. It includes

various items such as advances to suppliers, loans to customers, loans to

employees, advance tax payments (income tax, wealth tax) etc. This stands at

Rs.211.9 Crs. Following this, is the last line item on the Assets side and infact on the

Balance sheet itself. This is the ‘Other current assets’ which are not considered

important, hence termed ‘Other’. This stands at Rs.4.3 Crs.

To sum up, the Total Assets of the company would now be:-

Fixed Assets + Current Assets

= Rs.840.831 Crs + Rs.1298.61 Crs

= Rs. 2139.441 Crs, which is exactly equal to the liabilities of the company.

With this we have now run through the entire Assets side of the Balance sheet, and

infact the whole of Balance sheet itself. Let us relook at the balance sheet in its

entirety:

As you can see in the above, the balance sheet equation holds true for ARBL’s

balance sheet,

Asset = Shareholders’ Funds + Liabilities

Do remember, over the last few chapters we have only inspected the balance sheet

and the P&L statements. However, we have not analyzed the data to infer if the

numbers are good or bad. We will do the same when we look into the financial ratio

analysis chapter.

In the next chapter, we will look into the last financial statement which is the cash

flow statement. However, before we conclude this chapter we must look into the

many ways the Balance sheet and the P&L statement are interconnected.

7.5 – Connecting the P&L and Balance Sheet

Let us now focus on the Balance Sheet and the P&L statement and the multiple

ways they are connected (or affect) to each other.

Have a look at the following image:

In the image above, on the left hand side we have the line items on a typical

standard P&L statement. Corresponding to that on the right hand side we have

some of the standard Balance Sheet items. From the previous chapters, you already

know what each of these line items mean. However, we will now understand how

the line items in the P&L and the Balance Sheet are connected to each other.

To begin with, consider the Revenue from Sales. When a company makes a sale it

incurs expenses. For example if the company undertakes an advertisement

campaign to spread awareness about its products, then naturally the company has

to spend cash on the campaign. The money spent tends to decrease the cash

balance. Also, if the company makes a sale on credit, the Receivables (Accounts

Receivables) go higher.

Operating expenses includes purchase of raw material, finished goods and other

similar expenses. When a company incurs these expenses, to manufacture goods

two things happen. One, if the purchase is on credit (which invariably is) then

the Trade payables (accounts payable) go higher. Two, the Inventory level also

gets affected. Whether the inventory value is high or low, depends on how much

time the company needs to sell its products.

When companies purchase Tangible assets or invest in Brand building exercises

(Intangible assets) the company spreads the purchase value of the asset over the

economic useful life of the asset. This tends to increase

the depreciation mentioned in the Balance sheet. Do remember the Balance sheet

is prepared on a flow basis, hence the Depreciation in balance sheet is accumulated

year on year. Please note, Depreciation in Balance sheet is referred to as

the Accumulated depreciation.

Other income includes monies received in the form of interest income, sale of

subsidiary companies, rental income etc. Hence, when companies

undertake investment activities, the other incomes tend to get affected.

As and when the company undertakes Debt (it could be short term or long term),

the company obviously spends money towards financing the debt. The money that

goes towards financing the debt is called the Finance Cost/Borrowing Cost. Hence,

when debt increases the finance cost also increases and vice versa.

Finally, as you may recall the Profit after tax (PAT) adds to the surplus of the

company which is a part of the Shareholders equity.

Key takeaways from this chapter

1. The Assets side of the Balance sheet displays all the assets the company owns

2. Assets are expected to give an economic benefit during its useful life

3. Assets are classified as Non-current and Current asset

4. The useful life of Non-current assets is expected to last beyond 365 days or 12

months

5. Current assets are expected to payoff within 365 days or 12 months

6. Assets inclusive of depreciation are called the ‘Gross Block’

7. Net Block = Gross Block – Accumulated Depreciation

8. The sum of all assets should equal the sum of all liabilities. Only then the Balance

sheet is said to have balanced.

9. The Balance sheet and P&L statement are inseparable. They are connected to each

other in many ways.

Module 3 — Fundamental Analysis

Chapter 8

The Cash Flow statement

8.1 – Overview

The Cash flow statement is a very important financial statement, as it reveals how

much cash the company is actually generating. Is this information not revealed in

the P&L statement you may think? Well, the answer is both a yes and a no.

Consider the following scenario.

Assume a simple coffee shop selling coffee and short eats. All the sales the shop

does is mostly on cash basis, meaning if a customer wants to have a cup of coffee

and a snack, he needs to have enough money to buy what he wants. Going by that

on a particular day, assume the shop manages to sell Rs.2,500/- worth of coffee and

Rs.3,000/- worth of snacks. It is evident that the shop’s income is Rs.5,500/- for that

day. Rs.5,500/- is reported as revenues in P&L, and there is no ambiguity with this.

Now think about another business that sells laptops. For sake of simplicity, let us

assume that the shop sells only 1 type of laptop at a standard fixed rate of

Rs.25,000/- per laptop. Assume on a certain day, the shop manages to sells 20 such

laptops. Clearly the revenue for the shop would be Rs.25,000 x 20 = Rs.500,000/-.

But what if 5 of the 20 laptops were sold on credit? A credit sale is when the

customer takes the product today but pays the cash at a later point in time. In this

situation here is how the numbers would look:

Cash sale: 15 * 25000 = Rs.375,000/-

Credit sale: 5 * 25000 = Rs.125,000/-

Total sales: Rs.500,000/-

If this shop was to show its total revenue in its P&L statement, you would just see a

revenue of Rs.500,000/- which may seem good on the face of it. However, how

much of this Rs.500,000/- is actually present in the company’s bank account is not

clear. What if this company had a loan of Rs.400,000/- that had to be repaid back

urgently? Even though the company has a sale of Rs.500,000 it has only Rs.375,000/-

in its account. This means the company has a cash crunch, as it cannot meet its debt

obligations.

The cash flow statement captures this information. A statement of cash flows

should be presented as an integral part of an entity’s financial statements. Hence in

this context evaluation of the cash flow statement is highly critical as it reveals

amongst other things, the true cash position of the company.

To sum up, every company’s financial performance is not so much dependent on

the profits earned during a period, but more realistically on liquidity or cash flows.

8.2 – Activities of a company

Before we go ahead to understand the cash flow statement, it is important to

understand ‘the activities’ of a company. If you think about a company and the

various business activities it undertakes, you will realize that the company’s activities

can be classified under one of the three standard baskets. We will understand this

in terms of an example.

Imagine a business, maybe a very well established fitness center (Talwalkars, Gold’s

Gym etc) with a sound corporate structure. What are the typical business activities

you think a fitness center would have? Let me go ahead and list a few business

activities:

1. Display advertisements to attract new customers

2. Hire fitness instructors to help clients in their fitness workout

3. Buy new fitness equipments to replace worn out equipments

4. Seek short term loan from bankers

5. Issue a certificate of deposit for raising funds

6. Issue new shares to a few known friends to raise fresh capital for expansion (also

called preferential allotment)

7. Invest in a startup company working towards innovative fitness regimes

8. Park excess money (if any) in fixed deposits

9. Invest in a building coming up in the neighborhood, for opening a new fitness

center sometime in the future

10. Upgrade the sound system for a better workout experience

As you can see the above listed business activities are quite diverse however they

are all related to the business. We can classify these activities as:

1. Operational activities (OA): Activities that are directly related to the daily core

business operations are called operational activities. Typical operating activities

include sales, marketing, manufacturing, technology upgrade, resource hiring etc.

2. Investing activities (IA): Activities pertaining to investments that the company

makes with an intention of reaping benefits at a later stage. Examples include

parking money in interest bearing instruments, investing in equity shares, investing

in land, property, plant and equipment, intangibles and other non current assets etc

3. Financing activities (FA): Activities pertaining to all financial transactions of the

company such as distributing dividends, paying interest to service debt, raising fresh

debt, issuing corporate bonds etc

All activities a legitimate company performs can be classified under one of the

above three mentioned categories.

Keeping the above three activities in perspective, we will now classify each of the

above mentioned activities into one of the three categories /baskets.

1. Display advertisements to attract new customers – OA

2. Hire fitness instructors to help customers with their fitness workout – OA

3. Buy new fitness equipment to replace worn out equipments – OA

4. Seek a short term loan from bankers – FA

5. Issue a certificate of deposit (CD) for raising funds – FA

6. Issue new shares to few known friends to raise fresh capital for expansion (also

called preferential allotment) – FA

7. Invest in a startup company working towards innovative fitness regimes – IA

8. Park excess money (if any) in fixed deposit – IA

9. Invest in a building coming up in the neighborhood for opening a new fitness center

sometime in the future – IA

10. Upgrade the sound system for better workout experience- OA

Now think about the cash moving in and out of the company and its impact on the

cash balance. Each activity that the company undertakes has an impact on cash. For

example “Upgrade the sound system for a better workout experience” means the

company has to pay money towards the purchase of a new sound system, hence

the cash balance decreases. Also, it is interesting to note that the new sound system

itself will be treated as a company asset.

Keeping this in perspective, we will now understand for the example given above

how the various activities listed would impact the cash balance and how would it

impact the balance sheet.

Activity

Type

Rational

Cash

Balance

On Balance Sheet

Expenditure towards

Decreases

Treated as an asset as it increases

the brand value

Expenditure towards new

recruits

Decreases

Treated as an asset as it increases

the company’s intellectual capital

Expenditure towards new

equipment

Decreases

Treated as asset

Loan means cash inflow to

business

Increases

Loan is a liability

Deposits via CD means cash

inflow

Increases

CD is a liability

Issue of fresh capital means cash

inflow

Increases

Treated as a liability as share capital

increases

Investment in startup means

cash outflow

Decreases

Investment is an asset

Money parked in FD means cash

going out of business

Decreases

Equivalent to cash, hence

considered an asset

Investment in building means

cash going out of business

Decreases

Gross block considered an asset

Expenditure towards the sound

system

Decreases

Treated as an asset

The table above is colour coded:

1. Increase in cash is colour coded in blue

2. Decrease in cash is colour coded in red

3. Assets are colour coded in green and

4. Liabilities are colour coded in purple.

If you look through the table and start correlating the ‘Cash Balance’ and

‘Asset/Liability’ you will observe that:

1. Whenever the liabilities of the company increases the cash balance also increases

1. This means if the liabilities decreases, the cash balance also decreases

2. Whenever the asset of the company increases, the cash balance decreases

1. This means if the assets decreases, the cash balance increases

The above conclusion is the key concept while constructing a cash flow statement.

Also, extending this further you will realize that each activity of the company be it

operating activity, financing activity, or investing activity either produces cash (net

increase in cash) or reduces (net decrease in cash)the cash for the company.

Hence the total cash flow for the company will be:-

Cash Flow of the company = Net cash flow from operating activities + Net Cash flow from investing

activities + Net cash flow from financing activities

8.3 – The Cash Flow Statement

Having some insight into the cash flow statement, you would now appreciate the

fact that you need to look into the cash flow statement to review the company from

a cash perspective.

Typically when companies present their cash flow statement they split the

statement into three segments to explicitly show how much cash the company has

generated across the three business activities. Continuing with our example from

the earlier chapters, here is the cash flow statement of Amara Raja Batteries Limited

(ARBL):

I will skip going through each line item as most of them are self explanatory,

however I want you to notice that ARBL has generated Rs.278.7 Crs from operating

activities. Note, a company which has a positive cash flow from operating activities

is always a sign of financial well being.

Here is the snapshot of ARBL’s cash flow from investing activities:

As you can see, ARBL has consumed Rs.344.8 Crs in its investing activities. This is

quite intuitive as investing activities tend to consume cash. Also remember healthy

investing activities foretells the investor that the company is serious about its

business expansion. Of course how much is considered healthy and how much is

not, is something we will understand as we proceed through this module.

Finally, here is the snapshot of ARBL’s cash balance from financing activities:

ARBL consumed Rs.53.1Crs through its financing activities. If you notice the bulk of

the money went in paying dividends. Also, if ARBL takes on new debt in future it

would lead to an increase in the cash balance (remember increase in liabilities,

increases cash balance). We know from the balance sheet that ARBL did not

undertake any new debt.

Let us summarize the cash flow from all the activities:

Cash Flow from

Rupees Crores (2013-14)

Rupees Crores (2012-13)

Operating Activities

278.7

335.4

Investing Activities

(344.8)

(120.05)

Financing Activities

(53.1)

(34.96)

Total

(119.19)

179.986

This means the company consumed a total cash of Rs.119.19 Crs for the financial

year 2013 -2014. Fair enough, but what about the cash from the previous year? As

we can see, the company generated Rs.179.986 Crs through all its activities from the

previous year. Here is an extract from ARBL’s cash flow statement:

Look at the section highlighted in green (for the year 2013-14). It says the opening

balance for the year is Rs.409.46Crs. How did they get this? Well, this happens to be

the closing balance for the previous year (refer to the arrow marks). Add to this the

current year’s cash equivalents which is (Rs.119.19) Crs along with a minor forex

exchange difference of Rs.2.58 Crs we get the total cash position of the company

which is Rs.292.86 Crs. This means, while the company guzzled cash on a yearly

basis, they still have adequate cash, thanks to the carry forward from the previous

year.

Note, the closing balance of 2013-14 will now be the opening balance for the FY

2014 – 15. You can watch out for this when ARBL provides its cash flow numbers for

the year ended 31

March 2015.

At this point, let us run through a few interesting questions and answers:

1. What does Rs.292.86 Crs actually state?

1. This literally shows how much cash ARBL has in its various bank accounts

2. What is cash?

1. Cash comprises cash on hand and demand deposits. Obviously, this is a liquid asset of the

company

3. What are liquid assets?

1. Liquid assets are assets that can be easily converted to cash or cash equivalents

4. Are liquid assets similar to ‘current items’ that we looked at in the Balance sheet?

1. Yes, you can think of it that way

5. If cash is current and cash is an asset, shouldn’t it reflect under the current asset on

the Balance sheet?

1. Exactly and here it is. Look at the balance sheet extract below.

Clearly, we can now infer that the cash flow statement and the balance sheet

interact with each other. This is in line with what we had discussed earlier i.e all the

three financial statements are interconnected with each other.

8.4 – A brief on the financial statements

Over the last few chapters we have discussed the three important financial

statements of the company i.e the P&L statement, the Balance Sheet and the Cash

Flow statement of the company. While the Cash flow and P&L statement are

prepared on a standalone basis (representing the financial position for the given

year), the Balance Sheet is prepared on a flow basis.

The P&L statement discusses how much the company earned as revenues versus

how much the company expended in terms of expenses. The retained earnings of

the company also called the surplus of the company are carried forward to the

balance sheet. The P&L also incorporates the depreciation number. The

depreciation mentioned in the P&L statement is carried forward to the balance

sheet.

The Balance Sheet details the company’s assets and liabilities. On the liabilities side

of the Balance sheet the company represents the shareholders’ funds. The assets

should always be equal to the liabilities, only then do we say the balance sheet has

balanced. One of the key details on the balance sheet is the cash and cash

equivalents of the firm. This number tells us, how much money the company has in

its bank account. This number comes from the cash flow statement.

The cash flow statement provides information to the users of the financial

statements about the entity’s ability to generate cash and cash equivalents as well

as indicates the cash needs of a company. The statement of cash flows are prepared

on a historical basis providing information about the cash and cash equivalents,

classifying cash flows in to operating, financing and investing activities. The final

number of the cash flow tells us how much money the company has in its bank

account.

We have so far looked into how to read the financial statements and what to expect

out of each one of them. We have not yet ventured into how to analyze these

numbers. One of the ways to analyze the financial numbers is by calculating a few

important financial ratios. In fact we will focus on the financial ratios in the next few

chapters.

Key takeaways from this chapter

1. The Cash flow statement gives us a picture of the true cash position of the company

2. A legitimate company has three main activities – operating activities, investing

activities and the financing activities

3. Each activity either generates or drains money for the company

4. The net cash flow for the company is the sum of operating activities, investing

activities and the financing activities

5. Investors should specifically look at the cash flow from operating activities of the

company

6. When the liabilities increase, cash level increases and vice versa

7. When the assets increase, cash level decreases and vice versa

8. The net cash flow number for the year is also reflected in the balance sheet

9. The Statement of Cash flow is a useful addition to the financial statements of a

company because it indicates the company’s performance.

Module 3 — Fundamental Analysis

Chapter 9

The Financial Ratio Analysis (Part 1)

133

9.1 – A note on Financial Ratios

Over the last few chapters we have understood how to read the financial

statements. We will now focus our attention on analyzing these financial

statements. The best way to analyze the financial statements is by studying the

‘Financial Ratios’. The theory of financial ratios was made popular by Benjamin

Graham, who is popularly known as the father of fundamental analysis. Financial

ratios help in interpreting the results, and allows comparison with previous years

and other companies in the same industry.

A typical financial ratio utilizes data from the financial statement to compute its

value. Before we start understanding the financial ratios, we need to be aware of

certain attributes of the financial ratios.

On its own merit, the financial ratio of a company conveys very little information.

For instance, assume Ultratech Cements Limited has a profit margin of 15%, how

useful do you think this information is? Well, not much really. 15% profit margin is

good, but how would I know if it is the best?

However, assume you figure out ACC Cement’s profit margin is 12%. Now, as we

comparing two similar companies, comparing the profitability makes sense. Clearly,

Ultratech Cements Limited seems to be a more profitable company between the

two. The point that I am trying to drive across is that more often than not, Financial

Ratios on its own is quite mute. The ratio makes sense only when you compare the

ratio with another company of a similar size or when you look into the trend of the

financial ratio. This means that once the ratio is computed the ratio has to be

analyzed (either by comparison or tracking the ratio’s historical trend) to get the

best possible inference.

Also, here is something that you need to be aware off while computing ratios.

Accounting policies may vary across companies and across different financial years.

A fundamental analyst should be cognizant of this fact and should adjust the data

accordingly, before computing the financial ratio.

9.2 – The Financial Ratios

Financial ratios can be ‘somewhat loosely’ classified into different categories, namely

–

1. Profitability Ratios

2. Leverage Ratios

3. Valuation Ratios

4. Operating Ratios

The Profitability ratios help the analyst measure the profitability of the company.

The ratios convey how well the company is able to perform in terms of generating

profits. Profitability of a company also signals the competitiveness of the

management. As the profits are needed for business expansion and to pay

dividends to its shareholders a company’s profitability is an important consideration

for the shareholders.

The Leverage ratios also referred to as solvency ratios/ gearing ratios measures

the company’s ability (in the long term) to sustain its day to day operations.

Leverage ratios measure the extent to which the company uses the debt to finance

growth. Remember for the company to sustain its operations, it has to pay its bills

and obligations. Solvency ratios help us understand the company’s long term

sustainability, keeping its obligation in perspective.

The Valuation ratios compare the stock price of the company with either the

profitability of the company or the overall value of company to get a sense of how

cheap or expensive the stock is trading. Thus this ratio helps us in analysing

whether the current share price of the company is perceived as high or low. In

simpler words, the valuation ratio compares the cost of a security with the perks of

owning the stock.

The Operating Ratios, also called the ‘Activity Ratios’ measures the efficiency at

which a business can convert its assets (both current and noncurrent) into

revenues. This ratio helps us understand how efficient the management of the

company is. For this reason, Operating Ratios are sometimes called the

‘Management Ratios’.

Strictly speaking, ratios (irrespective of the category it belongs to) convey a certain

message, usually related to the financial position of the company. For example,

‘Profitability Ratio’ can convey the efficiency of the company, which is usually

measured by computing the ‘Operating Ratio’. Because of such overlaps, it is difficult

to classify these ratios. Hence the ratios are ‘somewhat loosely’ classified.

9.3 – The Profitability Ratios

We will look into the following ratios under ‘The Profitability Ratio’:

1. EBITDA Margin (Operating Profit Margin)

o EBITDA Growth (CAGR)

2. PAT Margin

o PAT Growth (CAGR)

3. Return on Equity (ROE)

4. Return on Asset (ROA)

5. Return on Capital Employed (ROCE)

EBITDA Margin:

The Earnings before Interest Tax Depreciation & Amortization (EBITDA)

Margin indicates the efficiency of the management. It tells us how efficient the

company’s operating model is. EBITDA Margin tells us how profitable (in percentage

terms) the company is at an operating level. It always makes sense to compare the

EBITDA margin of the company versus its competitor to get a sense of the

management’s efficiency in terms of managing their expense.

In order to calculate the EBITDA Margin, we first need to calculate the EBITDA itself.

EBITDA = [Operating Revenues – Operating Expense]

Operating Revenues = [Total Revenue – Other Income]

Operating Expense = [Total Expense – Finance Cost – Depreciation & Amortization]

EBIDTA Margin = EBITDA / [Total Revenue – Other Income]

Continuing the example of Amara Raja Batteries Limited, the EBITDA Margin

calculation for the FY14 is as follows:

We first calculate EBITDA , which is computed as follows:

[Total Revenue – Other Income] – [Total Expense – Finance Cost – Depreciation &

Amortization]

Note: Other income is income by virtue of investments and other non operational

activity. Including other income in EBITDA calculation would clearly skew the data.

For this reason, we have to exclude Other Income from Total Revenues.

[3482 – 46] – [2942 – 0.7 – 65]

= [3436] – [2876]

= 560 Crores

Hence the EBITDA Margin is:

560 / 3436

= 16.3%

I have two questions for you at this stage:

1. What does an EBITDA of Rs.560 Crs and an EBITDA margin of 16.3% indicate?

2. How good or bad an EBITDA margin of 16.3% is?

The first question is a fairly simple. An EBITDA of Rs.560 Crs means that the

company has retained Rs.560 Crs from its operating revenue of Rs.3436 Crs. This

also means out of Rs.3436 Crs the company spent Rs.2876 Crs towards its expenses.

In percentage terms, the company spent 83.7% of its revenue towards its expenses

and retained 16.3% of the revenue at the operating level, for its operations.

Now for the 2

question, hopefully you should not have an answer.

Remember we did discuss this point earlier in this chapter. A financial ratio on its

own conveys very little information. To make sense of it, we should either see the

trend or compare it with its peers. Going with this, a 16.3% EBITDA margin conveys

very little information.

To makes some sense of the EBITDA margin, let us look at Amara Raja’s EBITDA

margin trend for the last 4 years, (all numbers in Rs Crs, except EBITDA margin):

Year

Operating Revenues

Operating Expense

EBITDA

EBITDA Margin

2011

1761

1504

257

14.6%

2012

2364

2025

340

14.4%

2013

2959

2508

451

15.2%

2014

3437

2876

560

16.3%

It appears that ARBL has maintained its EBITDA at an average of 15%, and in fact on

a closer look it is clear the EBITDA margin is increasing. This is a good sign as it

shows consistency and efficiency in the management’s operational capabilities.

In 2011 the EBITDA was Rs.257 Crs and in 2014 the EBITDA is Rs.560Crs. This

translates to a 4 year EBITDA CAGR growth of 21%.

Please note, we have discussed the formula for CAGR in module 1.

Clearly, it appears that both EBITDA margin and EBITDA growth are quite

impressive. However we still do not know if it is the best. In order to find out if it is

the best one needs to compare these numbers with its competitors. In case of ARBL

it would be Exide batteries Limited. I would encourage you to do the same for Exide

and compare the results.

PAT Margin:

While the EBITDA margin is calculated at the operating level, the Profit After Tax

(PAT) margin is calculated at the final profitability level. At the operating level we

consider only the operating expenses however there are other expenses such as

depreciation and finance costs which are not considered. Along with these expenses

there are tax expenses as well. When we calculate the PAT margin, all expenses are

deducted from the Total Revenues of the company to identify the overall

profitability of the company.

PAT Margin = [PAT/Total Revenues]

PAT is explicitly stated in the Annual Report. ARBL’s PAT for the FY14 is Rs.367 Crs on

the overall revenue of Rs.3482 Crs (including other income). This translates to a PAT

margin of:

= 367 / 3482

=10.5 %

Here is the PAT and PAT margin trend for ARBL:

Year

PAT (in INR Crs)

PAT Margin

2011

148

8.4%

2012

215

8.9%

2013

287

9.6%

2014

367

10.5%

The PAT and PAT margin trend seems impressive as we can clearly see a margin

expansion. The 4 year CAGR growth stands at 25.48%, which is again good. Needless

to say, it always makes sense to compare ratios with its competitors.

Return on Equity (RoE):

The Return on Equity (RoE) is a very important ratio, as it helps the investor assess

the return the shareholder earns for every unit of capital invested. RoE measures

the entity’s ability to generate profits from the shareholders investments. In other

words, RoE shows the efficiency of the company in terms of generating profits to its

shareholders. Obviously, higher the RoE, the better it is for the shareholders. In fact

this is one of the key ratios that helps the investor identify investable attributes of

the company. To give you a perspective, the average RoE of top Indian companies

vary between 14 – 16%. I personally prefer to invest in companies that have a RoE of

18% upwards.

This ratio is compared with the other companies in the same industry and is also

observed over time.

Also note, if the RoE is high, it means a good amount of cash is being generated by

the company, hence the need for external funds is less. Thus a higher ROE indicates

a higher level of management performance.

RoE can be calculated as: [Net Profit / Shareholders Equity* 100]

There is no doubt that RoE is an important ratio to calculate, but like any other

financial ratios it also has a few drawbacks. To help you understand its drawbacks,

consider this hypothetical example.

Assume Vishal runs a Pizza store. To bake pizza’s Vishal needs an oven which costs

him Rs.10,000/-. Oven is an asset to Vishal’s business. He procures the oven from his

own funds and seeks no external debt. At this stage you would agree on his balance

sheet he has a shareholder equity of Rs.10,000 and an asset equivalent to Rs.10,000.

Now, assume in his first year of operation, Vishal generates a profit of Rs.2500/-.

What is his RoE? This is quite simple to compute:

RoE = 2500/10000*100

=25.0%.

Now let us twist the story a bit. Vishal has only Rs.8000/- he borrows Rs.2000 from

his father to purchase an oven worth Rs.10000/-. How do you think his balance

sheet would look?

On the liability side he would have:

Shareholder Equity = Rs.8000

Debt = Rs.2000

This makes Vishal’s total liability Rs. 10,000. Balancing this on the asset side, he has

an asset worth Rs.10,000. Let us see how his RoE looks now:

RoE = 2500 / 8000*100

= 31.25%

With an additional debt, the RoE shot up quite significantly. Now, what if Vishal had

only Rs.5000 and borrowed the additional Rs.5000 from his father to buy the oven.

His balance sheet would look like this:

On the liability side he would have:

Shareholder Equity = Rs.5000

Debt = Rs.5000

Vishal’s total liability is Rs. 10,000. Balancing this on the asset side, he has an asset

worth Rs.10,000. Let us see how his RoE looks now:

RoE = 2500 / 5000 *100

=50.0%

Clearly, higher the debt Vishal seeks to finance his asset, (which in turn is required

to generate profits) higher is the RoE. A high RoE is great, but certainly not at the

cost of high debt. The problem is with a high amount of debt, running the business

gets very risky as the finance cost increases drastically. For this reason inspecting

the RoE closely becomes extremely important. One way to do this is by

implementing a technique called the ‘DuPont Model’ also called DuPont Identity.

This model was developed in 1920’s by the DuPont Corporation. DuPont Model

breaks up the RoE formula into three components with each part representing a

certain aspect of business. The DuPont analysis uses both the P&L statement and

the Balance sheet for the computation.

The RoE as per DuPont model can be calculated as:

If you notice the above formula, the denominator and the numerator cancels out

with one another eventually leaving us with the original RoE formula which is:

RoE = Net Profit / Shareholder Equity *100

However in the process of decomposing the RoE formula, we gained insights into

three distinct aspects of the business. Let us look into the three components of the

DuPont model that makes up the RoE formula :

o Net Profit Margin = Net Profits/ Net Sales*100

This is the first part of the DuPont Model and it expresses the company’s ability to

generate profits. This is nothing but the PAT margin we looked at earlier in this

chapter. A low Net profit margin would indicate higher costs and increased

competition.

o Asset Turnover = Net Sales / Average Total asset

Asset turnover ratio is an efficiency ratio that indicates how efficiently the company

is using its assets to generate revenue. Higher the ratio, it means the company is

using its assets more efficiently. Lower the ratio, it could indicate management or

production problems. The resulting figure is expressed as number of times per year.

o Financial Leverage = Average Total Assets / Shareholders Equity

Financial leverage helps us answer this question – ‘For every unit of shareholders

equity, how many units of assets does the company have’. For example if the

financial leverage is 4, this means for every Rs.1 of equity, the company supports

Rs.4 worth of assets. Higher the financial leverage along with increased amounts of

debt, will indicate the company is highly leveraged and hence the investor should

exercise caution. The resulting figure is expressed as number of times per year.

As you can see, the DuPont model breaks up the RoE formula into three distinct

components, with each component giving an insight into the company’s operating

and financial capabilities.

Let us now proceed to implement the DuPont Model to calculate Amara Raja’s RoE

for the FY 14. For this we need to calculate the values of the individual components.

Net Profit Margin: As I mentioned earlier, this is same as the PAT margin. From our

calculation earlier, we know the Net Profit Margin for ARBL is 9.2%

Asset Turnover = Net Sales / Average Total assets

We know from the FY14 Annual Report, Net sales of ARBL stands at Rs.3437 Crs.

The denominator has Average Total Assets which we know can be sourced from the

Balance Sheet. But what does the word ‘Average’ indicate?

From ARBL’s balance sheet, the total asset for FY14 is Rs.2139Crs. But think about

this, the reported number is for the Financial Year 2014, which starts from 1

April 2013 and close on 31

March 2014. This implies that at the start of the financial

year 2014 (1

April 2013), the company must have commenced its operation with

assets that it carried forward from the previous financial year (FY 2013). During the

financial year (FY 2014) the company has acquired some more assets which when

added to the previous year’s (FY2013) assets totaled to Rs.2139 Crs. Clearly the

company started the financial year with a certain rupee value of assets but closed

the year with a totally different rupee value of assets.

Keeping this in perspective, if I were to calculate the asset turnover ratio, which

asset value should I consider for the denominator? Should I consider the asset value

at the beginning of the year or at the asset value at the end of the year? To avoid

confusion, the practice is to take average of the asset values for the two financial

years.

Do remember this technique of averaging line items, as we will be using this across

other ratios as well.

From ARBL’s annual report we know:

Net Sales in FY14 is Rs.3437Crs

Total Assets in FY13 is Rs.1770 Crs

Total Assets in FY14 is Rs.2139 Crs

Average Assets = (1770 + 2139) / 2

= 1955

Asset Turnover = 3437 / 1955

= 1.75 times

This means for every Rs.1 of asset deployed, the company is generating Rs.1.75 in

revenues.

We will now calculate the last component that is the Financial Leverage.

Financial Leverage = Average Total Assets / Average Shareholders Equity

We know the average total assets is Rs.1955. We just need to look into the

shareholders equity. For reasons similar to taking the “Average Assets” as opposed

to just the current year assets, we will consider “Average Shareholder equity” as

opposed to just the current year’s shareholder equity.

Shareholders Equity for FY13 = Rs.1059 Crs

Shareholders Equity for FY14 = Rs.1362 Crs

Average shareholder equity = Rs.1211 Crs

Financial Leverage = 1955 / 1211

= 1.61 times

Considering ARBL has little debt, Financial Leverage of 1.61 is indeed an

encouraging number. The number above indicates that for every Rs.1 of Equity,

ARBL supports Rs.1.61 of assets.

We now have all the inputs to calculate RoE for ARBL, we will now proceed to do the

same:

RoE = Net Profit Margin X Asset Turnover X Financial Leverage

= 9.2% * 1.75 * 1.61

~ 25.9%. Quite impressive I must say!

I understand this is a lengthy way to calculate RoE, but this is perhaps the best way

as in the process of calculating RoE, we can develop valuable insights into the

business. DuPont model not only answers what the return is but also the quality of

the return.

However if you wish do a quick RoE calculation you can do so the following way:

RoE = Net Profits / Avg shareholders Equity

From the annual report we know for the FY14 the PAT is Rs.367 Crs

RoE = 367 / 1211

= 30.31%

Return on Asset (RoA):

Having understood the DuPont Model, understanding the next two ratios should be

simple. Return on Assets (RoA) evaluates the effectiveness of the entity’s ability to

use the assets to create profits. A well managed entity limits investments in non

productive assets. Hence RoA indicates the management’s efficiency at deploying its

assets. Needless to say, higher the RoA, the better it is.

RoA = [Net income + interest*(1-tax rate)] / Total Average Assets

From the Annual Report, we know:

Net income for FY 14 = Rs.367.4 Crs

And we know from the Dupont Model the Total average assets (for FY13 and FY14) =

Rs.1955 Crs

So what does interest *(1- tax rate) mean? Well, think about it, the loan taken by

the company is also used to finance the assets which in turn is used to

generate profits. So in a sense, the debtholders (entities who have given loan to the

company) are also a part of the company. From this perspective the interest paid

out also belongs to a stakeholder of the company. Also, the company benefits in

terms of paying lesser taxes when interest is paid out, this is called a ‘tax shield’. For

these reasons, we need to add interest (by accounting for the tax shield) while

calculating the ROA.

The Interest amount (finance cost) is Rs.7 Crs, accounting for the tax shield it would

= 7* (1 – 32%)

= 4.76 Crs . Please note, 32% is the average tax rate.

Hence ROA would be –

RoA = [367.4 + 4.76] / 1955

~ 372.16 / 1955

~19.03%

Return on Capital Employed (ROCE):

The Return on Capital employed indicates the profitability of the company taking

into consideration the overall capital it employs.

Overall capital includes both equity and debt (both long term and short term).

ROCE = [Profit before Interest & Taxes / Overall Capital Employed]

Overall Capital Employed = Short term Debt + Long term Debt + Equity

From ARBL’s Annual Report we know:

Profit before Interest & Taxes = Rs.537.7 Crs

Overall Capital Employed:

Short term debt: Rs.8.3 Crs

Long term borrowing: Rs.75.9 Crs

Shareholders equity = Rs.1362 Crs

Overall capital employed: 8.3 + 75.9 + 1362 = 1446.2 Crs

ROCE = 537.7 / 1446.2

= 37.18%

Key takeaways from this chapter:

1. A Financial ratio is a useful financial metric of a company. On its own merit the ratio

conveys very little information

2. It is best to study the ratio’s recent trend or compare it with the company’s peers to

develop an opinion

3. Financial ratios can be categorized into ‘Profitability’, ‘Leverage’, ‘Valuation’, and

‘Operating’ ratios. Each of these categories give the analyst a certain view on the

company’s business

4. EBITDA is the amount of money the company makes after subtracting the

operational expenses of the company from its operating revenue

5. EBITDA margin indicates the percentage profitability of the company at the

operating level

6. PAT margin gives the overall profitability of the firm

7. Return on Equity (ROE) is a very valuable ratio. It indicates how much return the

shareholders are making over their initial investment in the company

8. A high ROE and a high debt is not a great sign

9. DuPont Model helps in decomposing the ROE into different parts, with each part

throwing light on different aspects of the business

10. DuPont method is probably the best way to calculate the ROE of a firm

11. Return on Assets in an indicator of how efficiently the company is utilizing its assets

12. Return on Capital employed indicates the overall return the company generates

considering both the equity and debt.

13. For the ratios to be useful, it should be analyzed in comparison with other

companies in the same industry.

14. Also, ratios should be analyzed both at a single point in time and as an indicator of

broader trends over time